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A Market-Beating Safety Net for Your Stocks

Dividends can protect your stock's downside.

When stocks start falling, many people start to worry about how low they'll go. Fortunately, you don't have to move all your money into CDs or coffee cans to protect yourself. One secret weapon could help safeguard your investments.

Think back to the recent market meltdown. With the economy in the doldrums, cyclically sensitive Home Depot(NYSE: HD) sputtered. Its shares, which had traded in the high $30s in 2007, languished in the $20s in 2008, even falling to less than $18 at one point. Though some investors feared the stock would keep falling, its dividend helped to prop it up.

Throughout its troubles, the company maintained its per-share dividend payout of $0.225 per quarter, or $0.90 per year. As Home Depot's price fell, its dividend yield -- the annual payout amount, divided by the current share price -- grew more tantalizing:

Date

Stock Price

Dividend Yield

January, 2007

$41

2.2%

January, 2008

$26

3.5%

January, 2009

$24

3.8%

March, 2009

$18

5.0%

January, 2010

$29

3.1%

May, 2010

$36

2.6%*

Data: Yahoo! Finance.*Based on increased, $0.95-per-year dividend.

A stealth insurance policyBetween January 2007 and January 2009, Home Depot's stock price was pretty much cut in half. Yet the dividend payout remained intact, so with the price halved, the yield doubled.

In an environment of ultra-low interest rates and general economic uncertainty, the yields of 3%, 4%, and even 5% that Home Depot offered did not go unnoticed. Those payouts may even have supported the stock to some degree. Without the dividend, more investors might have bailed out and waited for sunnier times to reinvest. But the dividend gave them a reason to stick around, and gave other investors a reason to buy: Home Depot would be paying them well while they waited.

In this way, dividends can provide downside protection for the stocks we buy.

Sure, some companies may encounter serious problems. They may even have to slash their dividends, as Citigroup and General Electric did in recent years. But healthy, growing, dividend-paying companies, carefully watched, can help you enjoy dividend payments in all kinds of economic environments. And those payouts can help prop up the share price in hard times.

My colleague Ilan Moscovitz confirmed this in his quest for dividend dynamos: "When I ran the numbers over the 2000-2002 bear market, I found that dividend-paying stocks outperformed non-dividend-paying stocks by an incredible 47 percentage points on average."

Seek growing payoutsThe key, then, is to include solid dividend-payers in your portfolio -- ideally those that increase their payouts substantially over time. The following companies maintained (or increased) their dividends during the recent recession, and each sports a four-star or maximum five-star rating from our CAPS community of investors:

Company

Dividend Yield

5-Year Avg. Dividend Growth

Payout Ratio

3-Year Avg. Annual Return

Percentage Points Better Than Industry

Procter & Gamble(NYSE: PG)

3.1%

11.4%

42%

1.8%

0.9

Intel(Nasdaq: INTC)

3.0%

19.4%

53%

0.5%

6.1

Coca-Cola(NYSE: KO)

3.4%

10.0%

55%

2.1%

0.6

Lockheed Martin(NYSE: LMT)

3.2%

21.9%

32%

(3.8%)

2.5

Chevron(NYSE: CVX)

3.9%

11.0%

41%

(0.3%)

9.4

Home Depot

2.8%

25.0%

54%

(1.5%)

3.5

IBM(NYSE: IBM)

2.1%

26.0%

21%

7.5%

2.0

S&P 500

(10.8%)

Data: Motley Fool CAPS, Morningstar.

All of these companies also have manageable payout ratios, reflecting the percentage of net income they pay out in dividends. A number on the high side -- 80% or greater -- should give investors pause

Clearly, stocks like these could offer considerable peace of mind during a market downturn. The above candidates might all merit further research, but if you just don't have the time, let us us to do most of the work for you! Take a free 30-day trial to our market-beating Motley Fool Income Investor service. There's no obligation to subscribe, and you'll enjoy full access to all of the team's research, along with its list of the most promising dividend payers with substantial total-return potential.

Longtime Fool contributor Selena Maranjian owns shares of Home Depot, General Electric,Coca-Cola and Procter & Gamble.Home Depot, Intel, and Coca-Cola are Motley Fool Inside Value recommendations. Coca-Cola and Procter & Gamble are Motley Fool Income Investor selections. The Fool has created a covered strangle position on Intel. Motley Fool Options has recommended a buy calls position on Intel. The Fool owns shares of Coca-Cola and Procter & Gamble. The Motley Fool isFools writing for Fools.

Author

Selena Maranjian has been writing for the Fool since 1996 and covers basic investing and personal finance topics. She also prepares the Fool's syndicated newspaper column and has written or co-written a number of Fool books. For more financial and non-financial fare (as well as silly things), follow her on Twitter... Follow @SelenaMaranjian